Food and non-food inflation

Inflation in Nepal is largely affected by rising food price in the country, which is a global phenomenon also in the present context. The main driving forces behind Nepals inflation - food and nonfood are Indias inflation and movements of international oil prices. However, inflation in food component has come down to single digit after a long time in October 2011. Non food inflation would go higher in the future if the present exchange rate trend (especially USD exchange rate appreciation) still goes to upward direction. Overall consumer price inflation in Nepal has been influenced by rising prices of food and petroleum products and rising inflation India. Although Nepal maintains an open border with India and pegs its currency to the Indian rupee, Nepals inflation rate does not go in lockstep with that of India. Rising inflation in Nepal has been mainly driven by food price inflation. Eliminating food prices from core inflation may provide an incorrect picture of underlying inflation trends, especially in low income countries, for three primary reasons: First, a core measure of inflation must have the same medium-term mean as the headline measure. However, food inflation is in many countries higher than nonfood inflation, making it likely that a core inflation measure excluding food prices will show lower inflation even in the long run than headline inflation. This is of particular concern among poorer countries, where in some cases food inflation is significantly higher than nonfood inflation. Second, excluding food prices from core measures (or assigning them a lower weight) due to their perceived transience is also in many cases unjustified. In the sample analyzed here, food inflation in many cases is quite persistent, in many countries more so than nonfood prices. This relationship is also particularly pronounced in poorer countries where food is a large share of the consumption basket. In such countries, the slow dissipation of food shocks could lead to higher expectations not only for food inflation but for overall inflation as well. Given the higher volatility of food price shocks, a core inflation measure that excludes food prices will miss these shocks.

Food Inflation and Nonfood Inflation There are two important points where differences in distribution of food and nonfood shocks can be significant. First, as Cecchetti (2007) points out, excluding food from a core measure of inflation is only justified when the long-run mean of food inflation is equal to the long run mean of nonfood inflation: if this is not the case, then core inflation will systematically underestimate headline inflation. That is, if policymakers are interested in the overall price level, ignoring food price dynamics only makes sense if these do not impact the long-run price level; if they do, then they have to be taken into account. Second, it is also important to look at the volatility of food price shocks. If food price shocks are more volatile than

nonfood price shocks, they add to the noise to signal ratio that policymakers contend with in assessing inflation. The larger and more frequent these shocks to food inflation are, the likelier it is that they not only lead to erroneous diagnoses of the level of underlying inflation, but also the likelier it is that those shocks can affect nonfood prices as well. This propagation mechanism may not exist everywhere, and this possibility is discussed below. If food shocks tend to be small, then even the long-run effect is likely to be minimal. However, if food shocks are larger and more volatile than nonfood shocks, then even if the propagation mechanism is weak, food shocks may have serious knock-on effects on nonfood prices. Core inflation indices can be derived in many ways, the end result in most advanced economies is to minimize or eliminate volatile categories, which often translates into excluding food and energy. While the greater role of food prices in emerging economies is acknowledged by all central bankers, core inflation measures excluding food price changes are also widely cited and can inform policy decisions. It is not clear, however, that the characteristics of both food and nonfood prices that justify the minimization of food price inflation in advanced-economy core measures apply in developing economies.

Food Price Inflation: Very few months (August 2007 March 2008 except in September) observed a single digit food price inflation ranging from 6.6 percent to 9.2 percent. Rest of the periods observed double digit inflation with a record of 21.5 percent hike in June 2009. Thus, increased food price has been one of the decisive forces for maintaining higher level inflation in Nepal.

Non-food Price Inflation: On the contrary, Non-food inflation showed a comfortable situation during the review period registering single digit increment ranged from 2.6 percent to 9.0 percent except in August to December, 2008. This is not only a question of the greater weight of food in the consumer basket, but also differences in the statistical properties and relationships between food and nonfood prices. This question is particularly important given the rising volatility and importance of food prices changes. During 2003-2007, when global commodity prices rose suddenly and rapidly, nonfood inflation rose quickly in many countries as well, underscoring the importance of looking at the relationship between food prices and headline inflation and questioning whether a focus on core measures of inflation might lead policymakers to underestimate the medium-term impact of changes in food prices. As the effects of the global financial crisis have receded, food prices have seemingly resumed this upward climb, and policymakers are again facing the issue of to what extent food price inflation should be accommodated.

In developing economies, where inflation is generally higher and more volatile, the signal to noise ratio is even lower, and there is even greater uncertainty about underlying developments. Thus while most central banks target headline inflation, policy decisions are often partially informed by other measures of inflation designed to provide a clearer image of underlying price developments than the headline price index. "Rising food prices are adding to inflationary pressures across the Asia-Pacific region. They are seen as a key downside risk to sustaining recovery in 2011. More startlingly high food prices in 2010 have kept 19.4 million people in poverty in the region, people who otherwise would have been out of poverty today," says the study by ESCAP's Macroeconomic Policy and Development Division (MPDD). Bad weather in key food-producing countries, increasing use of crops in biofuels and speculation in commodity markets have added to a long-term decline in agriculture investment and affected global food supplies, according to the study which examines the underlying causes of inflation in the region and its wider impact, and suggests short-, medium and long-term policy responses for governments and central banks.